lecture 5 topic 4 (2) Flashcards
Uncovered interest rate parity
states that interest rate differential between a pair of countries is (appx) equal to the expected rate of change in the exchange rate
(i$ - ipound) == E(e)
E(e) is the expected rate of change in the exchange rate
Currency carry trade
Unlike IRP, the uncovered interest rate parity often does not hold, giving rise to uncovered interest arbitrage opportunities
involves buying a high - yielding currency and funding it with a low - yielding currency, without any hedging
The carry trade is profitable if the interest rate differential is greater than the appreciation of the funding currency against the investment currency
Reasons for deviations from IRP
IRP holds quite well, but it may not hold precisely all the time due to (primarily) two main reasons
1) transaction costs:
Interest rate at which the arbitrage borrows tends to be higher than the rate at which he lends, reflecting the bid-ask spread
The foreign exchange market also has bid-ask spread, as the arbitrager must buy currencies at the higher ask price and sell at the lewer bid price
2) Capital controls:
Governments sometimes restict capital flows, impose taxes, or put outright bans
When the law of one price is applied internationally to a standard consumption basked, we obtain the theory of purchasing power parity (PPP)
PPP states the exchange rate between currencies of two countries should be equal to the ratio of the countries price levels of a commodity basket
Absolute purchasing power parity (PPP)
spot exchange rate (formula)
S = P$/Ppound
P$ = the dollar price of the standard consumption in the US
Ppound = the pound price of the same basket in the UK
e = pi$ - pieuro/(1+pieuro)
== pi$ - pieuro
The rate of change in exchange rate == inflation differential
When the PPP relationship is presented in the rate of change form we obtain the relative version of PPP
e = pi$ - pipound
Where
e = the rate of change in the exchange rate
pi$ and pipound are the inflation rates in the united states and UK respectively
if there are deviations from PPP
change is nominal exchagne rates cause changes in the real exchange rates, affecting the international competitive positions of countries
The real exchange rate q is founded by
q = 1 +pi$/(1+e)*(1+pieuro)
If ppp holds the real exchange rate will be unity (that is, q = 1), but when PPP is violated, the real exchange rate will deviate from unity.
What when q = 1 or q < 1 or q > 1
when q = 1 –> competitiveness of the domestic country unaltered
q < 1 –> competitiveness of the domestic country improves
q > 1 –> competitiveness of the domestic country deteriorates
Why does PPP not hold in real life
1) nontradable or nonstandardized goods
2) shipping costs
3) tariffs and quotas
The fisher effect
holds hat an increase (decrease) in the expectation inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country
(1+ nominal interest rate) = (1+ expected inflation) x( 1+real interest rate)
Formally the fisher effect is written as follows
i$ = p$ + E(pi$) + p$*E(pi$) == P$ * E(pi$)
Where p$ denotes the equilibrium expected “real” interest rate in the united states
Fisher effect implies that
The expected inflation rate is the difference between the nominal and real intereest rates in each country that is
E(pi$) = (i$ - p$)/(1+p$) == i$ - p$
E(pipound) = (ipound - ppound)/(1+Ppound) == ipound - Ppound
International fisher effect formula
E(pi$) - E(pipound) == i$ - ipound
E(pi$) - E(pipound) = E (e)
